Paying for Old Age

LIFE expectancy at birth for Americans is about 78. But many Americans will die well before then, while others, like Eunice Sanborn, who died in Texas last month, will live to be 114.

Anyone planning for retirement must answer an impossible question: How long will I live? If you overestimate your longevity, you might scrimp unnecessarily. If you underestimate, you might outlive your savings.

This is hardly a new problem — and yet not a single financial product offers a satisfactory solution to this risk.

We believe that a new product — a federally issued, inflation-adjusted annuity — would make it possible for people to deal with this problem, with the bonus of contributing to the public coffers. By doing good for individuals, the federal government could actually do well for itself.

The insurance industry sells an inflation-adjusted annuity that goes part of the way toward helping people cope with the possibility of outliving their savings. During your working years or at the time of retirement, you can pay a premium to an insurance company in exchange for the promise that the company will pay you a fixed annual income, adjusted for inflation, until you die.

But in a world in which A.I.G. had an excellent rating only days before it became a ward of the state, how can someone — particularly a young person — know for sure which insurance companies will be solvent half a century from now? Annuities aren’t federally guaranteed. The only backstops are state-based systems, and the current protection ceilings are sometimes modest. If an insurance company goes under, the retiree may end up with nothing close to what was promised.

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Keith Negley

The federal government can offer a product that solves that problem. Individuals would face no more risk of default than that associated with Treasury bills and other obligations backed by the United States.

Here’s how it would work. Initially, people who wanted to buy this insurance would enroll through one of the qualified retirement savings plans already offered to the public, like a 401(k) plan, and could choose this annuity option instead of, or in addition to, investments in stocks, bonds or mutual funds.

How much the payouts would be could be based on a variety of factors, including interest rates on government bonds; mortality tables that, among other things, take into account that healthier people are more likely to buy annuities; and administrative costs. This new product wouldn’t cost the government a penny. In fact, the Treasury would benefit. It is only an incremental move beyond issuing inflation-adjusted bonds, which the Treasury already does. By allowing the government to tap a new class of investors, the cost of government borrowing over all would probably drop.

Moreover, by expanding the government’s base of domestic investors, the plan would help address overreliance on foreign lenders, who now own close to half of all outstanding federal debt — nearly 10 times the proportion in 1970. True, the government would be on the hook if a technological breakthrough caused an unanticipated increase in life expectancy. But that’s a risk that the government is already bearing implicitly: that is, a drastic enough increase could threaten the solvency of private issuers of annuities as well as the many retirees who don’t have annuities, creating pressure for government bailouts of insurers or individuals. Taking on the risk explicitly and pricing the fair cost of this risk into the annuities is a far preferable route.

There is also the concern that government-issued annuities would crowd out private annuity sales. To the contrary: they could spur growth in private annuities. Since the inflation-adjusted monthly payments on such risk-free government annuities would be low, many retirees may choose to supplement them with riskier, higher-paying annuities.

Furthermore, insurance companies could be allowed to package the government-issued annuities with their own products, creating appealing combinations that mix safety and the potential for higher returns.

Our proposal is a winner for everyone. The Treasury could lower borrowing costs and diversify its investor base while acknowledging and budgeting for risk that it already bears. Individuals could eliminate the risk of living too long. By looking at the promised rate of return on the annuities, individuals will have a better sense of how much they need to save. The Eunice Sanborns of the world, as well as all taxpayers, would rest a little easier at night.

Henry T. C. Hu is a professor at the University of Texas School of Law. Terrance Odean is a finance professor at the University of California at Berkeley.

A version of this op-ed appears in print on February 26, 2011, on page A19 of the New York edition with the headline: Paying for Old Age. Today's Paper|Subscribe